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Friday, January 13, 2012

New Fed Nominee Jeremy Stein, Rethinking Monetary Policy

Jeremy Stein is always worth reading, but when President Obama nominated him in late December for a seat on the Federal Reserve Board of Governors, he became must-reading. In the latest issue of the American Economic Journal: Macroeconomics (2012, 4(1), pp. 266–282), Stein and co-author Anil Kashyap discuss "The Optimal Conduct of Monetary Policy with Interest on Reserves." In particular, they are thinking about how it might be possible to use monetary policy for two purposes: both in its traditional role of keeping inflation low and stimulating the economy in recessions, and also in an untraditional role of reducing the chance of future financial crises. The article isn't freely available on-line, although many students and faculty will have access to it through library subscriptions or membership in the American Economic Association.

When teaching the basics of monetary policy a few years ago, the emphasis was on how the Fed used "open market operations"--that is, buying and selling government bonds to banks--to make interest rates rise or fall. When the Fed bought bonds from banks, then the banks had more cash to lend out, and interest rates would fall. When the Fed sold bonds to band, and received cash from the banks, then the banks had less cash to lend out, and interest rates would rise. Through these open market operations, the Fed reacted to risks of higher inflation or economic slowdown, adjusting the lendable funds available to banks to achieve its desired level of interest rates.

This basic exposition pointed out that in theory the Federal Reserve had other policy tools, like adjusting the level of reserves that banks were required to hold with the Fed, but because those tools received little use in recent decades, little attention was paid to them.

But when the financial crisis hit in fall 2008, the Fed got a new policy tool: it can pay interest on the reserves that banks are require to hold at the Fed. Kashyap and Stein explain: "In October of 2008, the US Federal Reserve announced that it would begin to pay interest on depository institutions’ required and excess reserve balances, having just been authorized by Congress to do so. The Fed thereby joined a large number of other central banks that were already making use of interest on reserves (IOR) prior to the onset of the global financial crisis. Given the Fed’s current policy of keeping the federal funds rate near zero, IOR has not been a quantitatively important tool thus far. As of this writing, the rate being paid is only 25 basis points. However, IOR may turn out to be extremely useful going forward ..."

Thus, in the future, when the time comes for the Fed to raise interest rates, how should it do so? As Kashyap and Stein write: "When the Fed seeks to tighten monetary policy, should it raise the rate paid on reserves, contract the quantity of reserves, or some combination of the two?"

I had not known before reading this article that many central banks around the world have both tools available to them. Of course, because it’s a research journal of economics, Kashyap and Stein feel compelled to explain algebraic labels rather than using words: in particular, they discuss the level of interest on reserves, which they label rIOR, and the “scarcity value of reserves,” which they label as keep ySVR and can be thought of as the interest rate that would result from the level of reserves created by the traditional system of open market operations. They write:

"This question can be further motivated by observing the diversity of central bank practices before the financial crisis. At one extreme of the spectrum was the Federal Reserve, which set rIOR to zero, so that any variation in the funds rate had to come from quantity-mediated changes in ySVR . At the other extreme was the Reserve Bank of New Zealand, which in July 2006 adopted a “floor system” in which reserves were made sufficiently plentiful as to drive ySVR to zero, meaning that the policy rate was equal to rIOR . And in between were a number of central banks (e.g., the ECB and the central banks of England, Canada, and Australia) which used variants of a “corridor” or “symmetric channel” system. One approach to operating such a system is for the quantity of reserves to be adjusted so as to keep ySVR at a constant positive level (100 basis points being a common value), with rIOR then being used to make up the rest of the policy rate."

"Note that these corridor systems share a key feature with the floor system used by New Zealand. In either case, all marginal variation in the policy rate comes from variation in rIOR , with no need for changes in quantity of reserves. In this sense, the pre-crisis US approach was fundamentally different from that in many other advanced economies."

Kashyap and Stein point out that with these two separate policy tools--that is, the new tool of interest paid on reserves and the old tool of managing the level of bank reserves--it becomes possible for a central bank to tackle two goals. "We argue that, in general, it will be optimal for the central bank to take advantage of both tools at its disposal by varying both rIOR [the level of interest paid by the Fed to banks on their reserves] and ySVR [the "scarcity value" of reserves], with the mix depending on conditions in the real economy and in financial markets. The two-tools argument begins with the premise that monetary policy may have an important financial stability role in addition to its familiar role in managing the inflation versus output tradeoff."

During the financial crisis, banks and other financial institutions found themselves in trouble because they had all ramped up their level of short-term debt--that is, debt which came due quite soon on a daily or monthly basis and was commonly being rolled over (and over and over) each time it came due. When the financial crisis hit, it became impossible to roll over all this short-term debt, and so many financial institutions suddenly found themselves without funding. Kashyap and Stein argue that financial institutions will often have a tendency to take on too much short-term debt from society's point of view, because individual financial institutions are looking only at their own finances and not taking into account the risk that if they all take on too much short-term debt, the risk of a system-wide financial crisis goes up. Thus, a way to reduce the risk of financial crisis is to put limits on bank holdings of such short-term debt.

One way to do this is to use a broad notion of "reserve requirements." In theory, banks wouldn't just hold reserves based on the deposits from customers, but on any debt that they are depending on renewing in the short run. Kashyap and Stein explain: "First, within the traditional banking sector, reserve requirements should in principle apply to any form of short-term debt that is capable of creating run-like dynamics, and hence
systemic fragility. This would include commercial paper, repo finance, brokered certificates of deposit, and so forth. ... Going further, given that essentially the same maturity-transformation activities take place in the shadow banking sector, it would also be desirable to regulate the shadow-banking sector in a symmetric fashion. This suggests imposing reserve requirements on the short-term debt issued by nonbank broker-dealer firms, as well as on other entities (special investment vehicles, conduits, and the like) that hold credit assets financed with shortterm instruments, such as asset-backed commercial paper and repo. Alternatively, to the extent that many of these short-term claims are ultimately held by stable value money market funds that effectively take checkable deposits, a reserve requirement could be applied to these funds."

Kashyap and Stein explain that central banks around the world have been using changes in the reserve requirement as a policy tool to limit bank holdings of short-term debt, and to assure that banks have a sufficient capital cushion. "[A] number of central banks around the world use changes in reserve requirements as a key policy tool. For example, the Chinese central bank changed the level of reserve requirements six times in 2010, while moving their policy interest rate just once. ... India offers another intriguing case study. Since November 2004, the Reserve Bank of India has operated a corridor system of monetary policy. In the aftermath of Lehman Brothers’ bankruptcy filing, the Reserve Bank cut reserve requirements from 9.0 percent to 5.0 percent in a series of four steps between October 2008 and January 2009.... Finally, Montoro and Moreno (2011) study the use of reserve requirements in three Latin American countries: Brazil, Colombia, and Peru. They note that central banks in these countries raised reserve requirements in the expansion phase of the most recent credit cycle, and then, like the Reserve Bank of India, cut them sharply
after the bankruptcy of Lehman Brothers. They also argue that the motivation for this approach was explicitly rooted in a financial stability objective ..."

However, Kashyap and Stein suggest that rather than varying reserve requirements to limit short-term debt of financial institutions, instead the same goal can be accomplished by using the quantity of reserves that the Fed encourages financial institutions to hold. They conclude: "The introduction of interest on reserves gives the Federal Reserve a second monetary policy tool that, used properly, may prove helpful for financial stability purposes.By adjusting both IOR [interest paid to banks on their reserves] and the quantity of reserves in the system, the Fed cansimultaneously pursue price stability, as well as an optimal regime of regulating the
externalities created by short-term bank debt. Though to be clear, the latter would also require, in addition to the use of IOR, a significant expansion in the coverage of reserve requirements, as well as possibly an adjustment to their level."

Assuming that Stein makes it through the confirmation process and ends up on the Fed Board of Governors--which in a just world will happen more-or-less instantaneously--it will be interesting to see how these issues emerge. Will the Fed begin to focus on how to reduce the systemic risk of another financial crisis? Will it revive changes in reserve requirements as an active tool of monetary policy? Will the Fed's reserve requirement be expanded so that it is based not just on deposits but on all forms short-term borrowing, and for all financial institutions (not just banks)? Will it start to use interest paid on bank reserves as a way of moving interest rates, while controlling the quantity of bank reserves as a way of holding down on the amount of short-term debt in the financial sector? Will the central bank perhaps decide to pay different rates of interest on those bank reserve it requires from those bank reserves that are held in excess of the requirement?

Leave aside all the potential complexities here, many of which are discussed in the article, and which are certainly real enough. The most basic ways that we have thought about and taught monetary policy in the last few decades may be on the verge of change.